Why the S&P 500 Could Drop Substantially

Why the S&P 500 Could Drop SubstantiallyTo get a feel of how healthy the stock market really is, I like to look at the S&P 500. The S&P 500 is an index comprised of 500 of the largest and most liquid companies. Investors should be aware of the underlying trends for the S&P 500, as a portion of a stock’s move will be based on the underlying direction for the broader market.

The S&P 500 has certainly pulled back in the latest earnings season, but I think there’s more to go. This isn’t surprising, considering the large amount of uncertainty in the world. The U.S. has just had a presidential election, and the fiscal cliff issue is ongoing. China is still unable to regain its previous growth rate levels, and the problems in Europe are certainly not new to readers of Profit Confidential.

When looking at the S&P 500, I like studying the technical analysis of the situation in trying to determine the risk-reward scenario at any given point in time. One thing all investors should be aware of is that technical analysis cannot predict the future; however, it can give indications of where support and resistance levels are most likely to occur and the most probable direction. Much like a large boulder rolling down a hill, once a market starts to move in a direction, it’s not easy to overcome inertia, and many stocks will get caught up in its path.

 SPX SandP Large Cap Index Stock Market Chart

Chart courtesy of www.StockCharts.com

This is a three-year weekly chart of the S&P 500. There are many ways to look at technical analysis; I’m going to cover a couple that stand out to me in this chart. First, notice the upward-sloping trendlines. From 2010 to the summer of 2011, the S&P 500 moved upward substantially before finally breaking its trendline and pulling back substantially.

The S&P 500 has now clearly broken its trendline and is trying to regain the momentum to move back above its long-term trend, which started in the fall of 2011. Trendlines are significant in technical analysis, and the longer they’ve been established, the greater the importance one should place upon it.

No one indicator in technical analysis is perfect; rather, I use a combination of factors. The current level of the S&P 500 is not only at a long-term trendline, but it is also at a horizontal resistance level. As seen in the chart, this approximate area was resistance in the spring of 2012. Combining these two technical analysis indicators, this puts the current area for the S&P 500 having that much more overhead resistance.

Another factor when looking at technical analysis are divergences. Divergences in technical analysis occur when the price moves to new highs but the indicator does not follow. It’s a sign that the underlying strength is not as strong as it once was.

The S&P 500 hit a relative high in September, while the moving average convergence/divergence (MACD) indicator did not, as seen in the bottom part of the chart. A similar occurrence happened in the spring of 2011.

This does not necessarily mean that the market has to go down; however, when combined with other technical analysis indicators, such as a long-term trendline being broken, it certainly adds to the validity that the next most likely possibility is a substantial decline in the S&P 500. I think that if the S&P 500 were to break 1,350, my technical analysis would indicate the next level of support at approximately 1,270. If that were to fail as support, I wouldn’t expect to see much buying until 1,150 was attained.